Whether internal or external, auditors can play key roles during the adoption of ASC 842. Internal audit proficiency can help to set up controls and processes for transitioning to the new standard and post-compliance reporting. Sharing transition plans with your external auditors, on the other hand, will lay the groundwork to avoid surprises during the first audit after the adoption of ASC 842. In other words, it’s time to recognize that lease audit procedures under ASC 842 are changing and we’re here to help you understand what to expect.
The six audit assertions assessed for lease accounting
It isn’t anything new for auditors to assess risk and perform audit procedures at the assertion level. In understanding what to expect in your external audit, it’s important to understand how your auditors assess risk and the procedures designed to mitigate those risks. In the age of IT systems and cloud computing, auditors rely heavily on their client’s systems for audit evidence. For leases, auditors are looking for a detailed description of how their client’s leasing system and processes are designed and operating. This understanding helps to develop their audit procedures. Below, we will walk through the audit procedures that our firm uses to assess risk.
Completeness, a major audit area for leases in particular, asserts that all leases have been captured and properly capitalized on the balance sheet. One of the biggest changes under ASC 842 is that lessees are required to recognize a right-of-use (ROU) asset and a lease liability for operating leases. As such, an asset and liability will be recognized on the balance sheet for both operating and finance leases. The easiest approach to ensuring auditors don’t spend too much time on this assertion is to have the completeness evidence prepared before your auditor walks in the door.
A best practice is to reconcile rent expense as of the most recent reporting period, for example to the underlying lease agreements and cross-reference to your lease accounting software solution (or spreadsheet). Additionally, a customer should support procedures performed to ensure a full inventory of leases (considering embedded leases, IT assets, and equipment leases) have been evaluated. Absent this evidence, auditors will spend excessive time performing additional procedures to ensure the lease population is complete.
These procedures can range from searching through file cabinets, interviewing everyone in the contracting process, physical inventorying of assets, and reconciling rent expense on your behalf. These procedures can result in an extra audit bill, be time-consuming for your employees, and suggest to the audit firm that you may not have an appropriate process in place. You can also expect a deficiency or a written management letter on the subject.
Existence/Occurrence, while not a high risk area for leases, asserts whether or not the lease actually exists. Directionally, auditors generally don’t spend much time on this assertion as financial statement preparers may be incentivized to understate liabilities (i.e. lease liabilities). However, based on how management evaluates a business’ financial results, the company could be incentivized to overstate assets without regard for lease liabilities, therefore, the auditors would spend some time ensuring that physical assets and contracts exist and/or occurred.
Valuation/Allocation asserts the proper present value calculations of your leases. The primary drivers of this calculation are payment streams, lease term, and discount rates. Auditors will spend time ensuring these components agree to the contract or have evidence to support them.
Additionally, the company will want to understand the procedures the software provider performs to evaluate accuracy of calculations and reports. An Agreed-Upon Procedures (AUP) report on these calculations from a reputable firm can help considerably with this. An AUP report can significantly reduce the required testing performed by the company and its auditors and provides assurance over calculations.
Discount rates receive audit scrutiny. Management needs to ensure there is a documented rationale supporting the accounting policy. A white paper document is the best deliverable for the auditors on this topic. Commonly, auditors will utilize valuation specialists to get comfortable with the present value calculations and the discount rate model.
Cut-off asserts whether or not the lease has been recorded in the correct accounting period. As a lessee, if you have a lease that commences after your ASC 842 transition date, the lease should be recognized after your transition date, on the lease commencement (or possession) date. To test this, auditors will select leases before and after your transition or reporting date and ensure they are recorded within the proper period.
For companies that took the package of practical expedients, the cut-off procedures would be focused on leases after the transition date, since the determination of the lease term and classification would not change in transition. However, there is a hindsight practical expedient available that would allow companies to re-evaluate lease term in transition. If a company utilizes the hindsight practical expedient, the auditor will need to perform cut-off procedures before and after transition.
Rights/Obligations asserts that assets are actually owned (or have the right to own) and liabilities are actually owed. With leases, the risks are somewhat neutralized as they result in asset and liabilities that net to approximately zero. However, as mentioned above in Existence/Occurrence, a company’s financial incentives could align in such a manner that this assertion could become high risk.
6) Classification/Presentation & Disclosure
Classification/Presentation & Disclosure asserts that transactions have been properly classified in the financial statements. For leases, the risk is that operating leases are improperly classified as finance leases (for which interest expense is recorded) or as short-term leases (whereby the lease liability and corresponding right of use asset are not recorded on the balance sheet), or vice versa. Due to income statement impact of misclassification (i.e. EBITDA), this is a major area of audit scrutiny.
To test classification, an auditor might select a sample of leases and reperform the ASC 842 classification testing. Some software solutions, like LeaseQuery, maintain this testing evidence along with the physical PDF agreements so it’s easy for an auditor to reperform.
In our experience, many customers have chosen to use the package of practical expedients upon transition to ASC 842. If so, the lease classification (assuming it was correctly determined under ASC 840) for a company’s lease agreements would not change (and therefore would generally not be subject to re-testing in audit) during transition.
It’s important to understand the audit assertions and related testing procedures, and the extent of these procedures should demonstrate to companies the value of a proven lease accounting solution. Not only will a good tool make transitioning to the new standard easier and more accurate, a solution that houses all of the audit-ready reports in one location will make an auditor’s job a lot more efficient as well.
Easing internal control testing
Customers will benefit from a software solution that not only provides a SOC 1 Type 2 report covering the period under audit but one with a clean or unqualified audit opinion on its internal controls over financial reporting. SOC 1 reports will provide the company with assurance that items such as logical access and program change procedures are operating effectively throughout the period. An effective SOC 1 can significantly reduce the required testing performed by the company and its auditors and provides assurance over controls.
Key considerations for internal audit controls
One area of implementation that can significantly affect a company’s efforts to establish ASC 842 compliance is documented internal controls. In an ideal situation, businesses have a contracting process in place to identify whether their agreements contain assets (and potentially a lease agreement) or not. This process is a centralized contract management solution that shows all contracts going through that system for approval. In a less than ideal but workable situation, contracting is decentralized and key team members are surveyed on a periodic basis for lease identification purposes.
For lease accounting, there are two types of recommended controls:
1) Preventative Controls:
As you might expect, these are controls that prevent errors on the front end of a process. Since leases initiate with the execution of a contract, it’s logical to insert a control in this process to prevent any leases from slipping through the cracks. A very simple preventative control in lease accounting is to insert a brief question “does this agreement contain property or equipment?” If there is an electronic workflow for contracting, this question can be inserted into that process. If no workflow exists, perhaps utilize a cover page for approvals and include this question. This is the starting point for the lease accountant to perform the ASC 842 lease identification process.
It’s important for companies to keep the preventative controls as simple as possible. Too many preventative controls can create bottleneck issues in the contracting process. The last thing you want is for accounting compliance to burden your business processes.
2) Detective Controls:
These are controls you can do periodically. For example, a detective control could include reviewing a listing of all contracts executed and the related lease accounting conclusions, or analytical procedures, such as analyze rent expense per month or look at the Right of Use assets as a percentage of rent expense. Different metrics or ratios can be employed to help identify missed leases. These controls are typically done by the key owners of that area, meaning a lease accountant would be the owner of the lease’s detective controls.
A proper lease accounting solution can help consolidate a significant portion of the detective control reporting in one area. Internal users or external auditors can quickly run a listing of all the leases within the solution that are active in the period and compare to the number of amortization tables you have, and immediately locate and correct any major disconnects between the two.
How to improve the audit process for lease accounts
ASC 842 isn’t just a learning curve for businesses, each new assessment is a learning curve for auditors as well. It’s important to recognize that we’re all in this together and everyone wants to succeed. However, there are a few things your company can do to set your business up for a successful post-transition audit.
- Do the research on what to expect during your first post-transition audit. There are several great resources available to help accountants feel at ease during this process. LeaseQuery has put together this article below, complete with a short video and free guide, to help get you started.
- Be proactive and get with your auditors before they come on-site to ask what you can expect from them during your first audit under the new standards.
- Set up a planning meeting with your auditors specifically around lease accounting. You can discuss what their plan is for that audit area and ensure you have all the evidence they will be looking for ready to go.
- Implement a lease accounting solution built specifically for accounting compliance. If possible, find one that already has a reputable SOC 1 report. Having one solution that both your company and your auditors can quickly log in to and pull supporting document/reports from will make finding evidence for each assertion a breeze.
Before doing any of this, it’s imperative to step back and take into consideration that your first lease audit under the ASC 842 standard is going to be a tough one. On a go-forward basis however, this process should be easier as the accounting policies will be established, and only the new activity consisting of new leases, modifications, and terminations, will be subject to audit. But for now, everybody is new to this and when businesses work with their auditors directly before, during, and after the process, everyone is guaranteed to feel a little more at ease.
About LBMC: LBMC is the largest CPA firm in Tennessee and has been helping public and non-public companies transition to ASC 842 for the last 2-3 years. Offering a full suite of lease accounting consulting solutions, we scale the offerings based on the needs of your organization. Whether you need an incremental borrowing rate model, a failed sale leaseback transition white paper, lease data extraction, or full project management over your 842 implementation, we are here to be your trusted advisor.